Underinvestment Problem
What it is
The underinvestment problem occurs when a highly indebted firm forgoes positive net present value (NPV) investments because expected returns would flow primarily to creditors rather than to shareholders. Managers acting in shareholders’ interest then reject projects that would increase the firm’s total value, producing suboptimal investment outcomes.
How it works
- Agency conflicts among managers, shareholders, and debtholders shape investment choices.
- If new-project cash flows are likely to be absorbed by existing debt service, equity holders receive little or no benefit. Rationally, they may oppose the project even if it raises the firm’s overall value.
- This creates a perverse incentive: profitable opportunities are passed up, reducing future growth and firm value.
Theoretical context
- The problem is associated with Stewart C. Myers’ analysis of corporate borrowing: firms with risky debt may decline positive-value investments because creditors capture too much of the upside.
- It contradicts the Modigliani–Miller idea that financing choices do not affect real investment decisions. In practice, leverage can and often does influence whether new projects are undertaken.
Debt overhang
- Debt overhang is a specific, acute form of underinvestment: when debt is so large that virtually all future earnings must go to creditors, leaving no internal funds for new investment.
- Consequences:
- Firms cannot access additional borrowing on reasonable terms.
- Shareholders lose both current claims and future growth potential.
- Long-term competitiveness and innovation suffer.
- Sovereign debt overhangs produce similar effects at the national level, leading to underinvestment in infrastructure, education, and healthcare and to stagnant growth.
Economic implications
- Widespread underinvestment reduces aggregate productivity, weakens competition, and slows technological progress.
- It can raise systemic risk if many firms within a sector or country are simultaneously constrained.
Mitigating underinvestment
Firms and policymakers can use several approaches to reduce underinvestment risk:
– Reduce leverage: pay down debt where possible to restore incentive alignment.
– Restructure obligations: renegotiate debt terms, extend maturities, or convert debt to equity to share upside more fairly.
– Raise new capital: issue fresh equity or hybrid instruments that allocate future returns to shareholders.
– Contract design: include covenants or convertible securities that preserve managerial ability to invest.
– Governance and signaling: credible commitment to maintain a minimum investment budget or create project-specific financing that isolates returns from old debt claims.
– Policy interventions: in extreme cases, government guarantees, recapitalizations, or targeted subsidies can unlock socially valuable investment.
Key takeaways
- Underinvestment arises when debt burdens make shareholders unwilling to fund projects that would mainly benefit creditors.
- It undermines firm growth and can have broad economic costs.
- Solutions focus on realigning incentives through deleveraging, restructuring, fresh capital, better contract design, and, where appropriate, policy support.